Mini-Course Series - Income (Part 7) by Institute of Business & Finance

MINI-COURSE SERIES

RETIREMENT INCOME Part VII

RETIREMENT INCOME

EQUITY-INDEXED ANNUITY As previously described, EIAs guarantee minimum interest earnings but links excess earnings to increases in an identified equity (or bond) index. Because of the guarantees, it is generally not considered a security and therefore can be sold by agents who are not equity licensed. The workings of an equity-indexed annuity (EIA) can be quite complicated and it is important for the agent to understand the product. Market conduct and EIA disclosure are important issues. Because they can have so many “moving parts,” the following discussion provides, at best, only a general outline of EIAs. Individual contracts can vary greatly. Next generation products are being introduced with new features and new complexities. The EIA is particularly attractive to individuals who are concerned about the safety of principal but who want the opportunity to experience market-related gains. Ideally, they should be an easily understood product that provides the benefits of market appreciation without the risk of losing principal. In reality, they are likely to be faced with an array of products that are difficult to fully understand. Both single premium and flexible premium contracts have been introduced. There are usually no sales charges (front-end loads), management fees or mortality costs. There are often large penalties for early withdrawals. Both level and declining surrender charges are used. Contracts are linked to the growth of an index over a period that can range from one to 10 years, although four to seven years appear most popular. This is referred to as the “term” of the contract or the policy period. While growth can be linked to the performance of virtually any index, the large majority of EIAs use the S&P 500 Index. Virtually all EIAs that use the S&P refer to the version that excludes dividends. The other (rarely used) is the total return version and determined using dividend reinvestment. Central to the indexed annuity is a guarantee of principal at term end. This is done by taking a set percentage of the purchase amount and accruing interest at a given percent for the contract term (e.g., 90% of a $100,000 deposit plus 3% over seven years). The reason that most contracts use 90% of deposit and 3% for earnings is due to state law minimum guarantee requirements for fixed annuities. Most contracts use one of three different methods to determine contract gain. For example, assume that upon issue of a contract with a six-year term the S&P 500 Index was 700. Thereafter the index stood as follows:

PART VII

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RETIREMENT INCOME

End Of Year

S&P Index

781

834

823

871

904

880

Point-To-Point

25.7%

High-Water Mark

29.1%

Ratchet (28%)

11.6%

6.8%

5.8%

3.8%

Using the point-to-point method the gain is calculated using the beginning point of 700 and ending point of 880 (880 - 700 = 180 รท 700 = .2571). In contrast, the high-water mark method, also known as the discrete look-back method, uses the highest point of 904 (904 - 700 = 204 รท 700 = .2914). The ratchet method, also known as the annual reset method, calculates gain by adding up the sum of annual gains (11.57 + 6.79 + 0 + 5.83 + 3.79 = 27.98). A drop in the index is counted as zero. Unlike the other methods, this locks in gains and annually resets the starting point of the index. Earnings for high-water mark and point-to-point are not credited until the end of the term, thus there is no compounding of interest earned. Averaging can be done daily, monthly or annually. The usual effect of averaging is to increase the rate in a decreasing market and reduce the rate in a rising market (e.g., averaging the monthly gains the first year would likely result in less than 11.57% gain). A cap (maximum rate) may be set on annual gains in the contract. The participation rate is the percentage of the index movement that will be credited (this can vary widely from 40% to over 100%). Some contracts guarantee the participation and/or cap rate for the term of the contract. Liquidity features can include nursing home/hospitalization/terminal illness waivers, partial surrenders and penalty-free withdrawals (e.g., 10% per year). However, loans are not usually allowed. At the end of contract term the owner can: (1) renew for another term (2) make a tax-free exchange into another fixed or variable annuity, (3) surrender the contract without penalty or (4) annuitize the contract.

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RETIREMENT INCOME

TAXATION OF ANNUITIES Premiums Generally, premiums paid into an annuity are only deductible if they represent contributions to a qualified retirement plan or traditional IRA.

Cash Value Build-Up Provided the annuity contract meets the requirements of Internal Revenue Code Section 72 and a “natural person” owns the annuity, interest or other earnings on the funds inside the annuity contract will not be currently taxed. However, if the owner is a corporation, or other entity that is not a natural person, the earnings on contributions made after February 28, 1986, are subject to current taxation. One broad exception to this rule is when an annuity is held by a trust, corporation or other “non-natural” person as an agent for a natural person, in which case the annuity is not subject to current taxation. There are additional exceptions to this non-natural rule with other types of annuities.

Withdrawals The taxation of withdrawals from or partial surrenders of an annuity depends upon the date that the annuity contract was first entered into: 1.

Entered into after August 13, 1982—Amounts received are taxed under “interest first rule,” meaning that they are taxable to the extent that the cash value exceeds the investment in the contract (i.e., treated as distributions of interest first and thereafter as recovery of cost).

Entered into on or before August 13, 1982—Amounts received are taxed under “cost recovery rule,” meaning they are not taxable to the extent of the annuity owner’s investment in the contract made on or before August 13, 1982 (i.e., treated as recovery of preAugust 14, 1982 cost and thereafter as taxable interest).

Different rules apply to amounts received under qualified retirement plans, Section 403(b) annuities and Individual Retirement Arrangements.

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RETIREMENT INCOME

Premature Distribution Penalty Tax Subject to certain exceptions, any distribution from an annuity prior to the Investment In Contract Exclusion Ratio = Expected Return taxpayer (payee) having reached age 59 ½ is subject to a 10% penalty tax on the taxable portion of the annuity payment. For example, assume that the annuity holder purchased an annuity for $25,000 and thereafter surrendered it at age 55 for $32,000. The amount subject to ordinary income taxes and the 10% penalty tax is the gain of $7,000 (32,000 – 25,000 = 7,000). One exception commonly used to avoid this 10% penalty tax allows for penalty-free payments to a taxpayer of any age, provided they are part of a “series of substantially equal periodic payments” that are made at least annually for the life of the taxpayer, or for the joint lives or joint life expectancies of the taxpayer and a designated beneficiary (e.g., a joint and survivor annuity). However, payments not subject to the 10% penalty by reason of this exception may be subject to recapture if the series of payments is modified (other than by reason of death or disability).

Benefit Payments The rule governing income taxation of payments received from an annuity is designed to return the purchaser’s investment in equal tax-free amounts over the annuity’s payment period. The balance of each payment must be included in income. Therefore, each payment is generally part nontaxable return of cost and part taxable income. Expected Return—To calculate the annuity’s exclusion ratio, expected return is divided into the investment in the contract. If payments are for a fixed period or fixed amount with no life expectancy involved, the expected return is equal to the sum of the guaranteed payments. If payments are to continue for one life or multiple lives, the expected return is determined by multiplying the sum of one year’s annuity payments by the life expectancy of the measuring life or lives. The life expectancy multiple or multiples are obtained from a series of Annuity Tables provided by the IRS.

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RETIREMENT INCOME

Exclusion Ratio With Fixed Return—This ratio identifies the portion of the annuity payment not taxed (i.e., that portion representing basis in the contract). It is expressed as a fraction, or as a percentage, and is determined by dividing the investment in the contract by its expected return. For example, assume that a contract holder purchases an annuity for $100,000 and elects an annuity certain paying $1,200 per month for 10 years. The expected return for a fixed period or fixed amount with no life expectancy involved is the sum of the 69.4%. (It is rounded to the nearest tenth of a percent.) Exclusion Ratio =

100,000 144,000

= 69.4%

This means that 69.4%, or $833 of every monthly payment is excluded from income (1,200 balance of $367 is included as income (1,200 – 833 = 367). Exclusion Ratio With Life Expectancy—Assume the contract holder is age 58, purchases an annuity for $100,000 and elects to receive a life annuity paying $700 monthly for life (i.e., a single life “pure” annuity). The expected return is determined by multiplying the $700 per month payment by 12 to arrive at the yearly payment of $8,400 and then multiplying this amount by the contract holder’s life expectancy (25.9 years). The expected return is $217,560 Exclusion Ratio =

Exclusion Ratio =

Investment In Contract Expected Return 100,000 217,560

= 46.0%

This means 46.0% ($322) of every monthly payment may be excluded from income (700 .460 = 322). The balance of $378 is included in income (700 - 322 = 378). The yearly is after December 31st, 1986, this exclusion ratio applies to payments received until the investment in the contract is fully recovered. Once the cost has been recovered, all payments are fully includable in income (i.e., the exclusion ratio no longer applies once the annuitant reaches his life expectancy). In this example, the contract holder is fully taxed on the monthly payment of $700 after 311 months of payments (100,000

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IBF | MINI-COURSE SERIES

RETIREMENT INCOME

Exclusion Ratio With Guaranteed Payments—Assume the contract holder is age 58, and purchases an annuity for $100,000, electing to receive a life annuity paying $550 per month for life with payments guaranteed for 20 years (i.e., a single life 20-year-period-certain annuity). The expected return is determined by multiplying the $550 monthly payment by 12 to arrive at the yearly payment of $6,600 and then multiplying this amount by the contract holder’s life expectancy (25.9 years) obtained from the unisex Table V (Ordinary Life Annuities One Life 170,940).

Before calculating the exclusion ratio the investment ($100,000) must be reduced to account for the value of the guarantee. The percent value of the guaranteed refund is 9% (from IRC Table VII for age 58 and 20 years). This is multiplied by the unadjusted investment in the contract ($100,000) to determine the value of the refund feature ($9,000). The value of the refund feature is then subtracted from unadjusted contract investment to determine the adjusted investment ($91,000). The exclusion ratio is 53.2%. Exclusion Ratio = Exclusion Ratio =

Investment In Contract Expected Return 91,000 170,940

= 53.2%

This means that 53.2% ($293) of every monthly payment may be excluded from income (550 - 293 = 257). The rst agraph above, if the annuity starting date is after December 31 , 1986, once the investment in the contract has been recovered all payments are fully includable in income.

Estate Taxation of Annuities The estate taxation of an annuity will typically differ depending upon whether the annuity is in the accumulation phase or distribution phase. 1. Accumulation Phase—The value must generally be included in the annuity owner’s gross estate. If the decedent furnished only part of the annuity’s purchase price, the estate includes only a proportional share of the annuity’s value. a. Owner is also the annuitant—The value of the annuity death benefit is included in the owner’s estate. b. Owner is not the annuitant—If the owner dies first, then the value included in the owner’s estate is apparently the amount that it would cost to purchase a comparable annuity contract. If the annuitant dies first, the annuity death benefit is generally not included in the gross estate of the annuitant, but it is a taxable gift from the surviving annuity owner to the beneficiary.

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RETIREMENT INCOME

2. Distribution Phase—The following assumes the “annuity holder” is both owner and annuitant. If payments were made under a straight life annuity, payments cease upon the annuity holder’s death; there is no remaining property interest, nothing is passed to survivors and nothing is included in the annuity holder’s estate. The value of any survivor benefits is included in the annuity holder’s estate. Benefits passing to a surviving spouse generally qualify for the marital deduction.

Gift Taxation of Annuities If an individual purchases an annuity, names herself as the annuitant and immediately gives the annuity contract to another person, the value of the gift is considered to be the amount of premium paid for the annuity. If the contract is held for a period of time after it is purchased, then the gift tax value is the single premium that the life insurance company would charge for an annuity providing the same benefits on the life of a person who is the same age as the annuitant when the gift is made. These gifts will not be subject to gift taxes if they are less than the annual exclusion amount. Premiums paid on the annuity will also qualify for the annual exclusion. An individual who pays premiums on an annuity contract owned by another individual is considered to make a gift of the premium amounts.

PART VII

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RETIREMENT INCOME

THINGS TO DO 

Your Practice

Talk to insurance clearing houses that offer a wide range of products from a number of different companies. Ask internal and external wholesalers what alternatives to EIAs they recommend. Determine what kind of tax savings you can create for some of your clients you believe would be good candidates for annuitization. 

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

PART VII

IBF | MINI-COURSE SERIES